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Category: Soap Box

Soapbox: Basel 3 – it matters for gold

'Basel 3' sounds like the brand name of a nasal spray to combat hay fever. Or the third instalment (yes, there have been Basel 1 and Basel 2) of a hor...

26 May 2021

Gary Mead

‘Basel 3’ sounds like the brand name of a nasal spray to combat hay fever. Or the third instalment (yes, there have been Basel 1 and Basel 2) of a horror movie sequence.

But it’s much more important – if rather more obscure – than either of those things and it threatens radically to change the gold world. The connection is convoluted, but crucial.

We are still feeling the effects of the last great banking crash, that of 2008. Almost 13 years on, international banking regulators (grouped together at the Bank for International Settlements or BIS) are just about to introduce a mechanism which they hope will fend off the worst if (surely that should be ‘when’?) another systemic failure happens.

The Basel Committee on Banking Regulations and Supervisory Practices, based at the BIS in Basel, Switzerland, started life at the end of 1974 after – there’s nothing new under the sun – the collapse of the Herstatt Bank, a middle-sized bank in what was then West Germany. Herstatt went bust because it had borrowed too much to stake bad bets on the direction of the US dollar. A bank gets into trouble because it borrows too much and makes poor risk decisions; sounds familiar.

When it collapsed Herstatt had accumulated losses of almost $30 million (£21 million) against assets of just $2.5 million (£1.76 million). Herstatt’s bankruptcy brought to light systemic risks associated with the increasing internationalisation of banks. That’s when Basel 1 appeared. Basel 2, which we are still living with, happened in June 2004 and was “aimed at rewarding and encouraging continued improvements in [bank] risk measurement and control”. Basel 2 failed; the events of 2008 showed that.

When the heavily indebted US investment bank Lehman Brothers collapsed in September 2008 people began to fret about the collapse of the global credit system. The Basel Committee (as it’s now known) set about trying to “strengthen the regulation and supervision of internationally active banks”. Basel Committee wheels grind slowly but surely.

Two years later, in 2010, the Committee issued a draft of proposals (Basel 3), aimed at the creation of a “global regulatory framework for more resilient banks and banking systems”. Among the many pages of Basel 3 you can find a proposal to raise minimum liquidity coverage ratios for banks and to introduce a Net Stable Funding Ratio (NSFR). Some of Basel 3 will take effect for European banks at the end of June. In the UK, all changes are due to become effective as of 1 January 2023.

The goal of these new regulations is to limit risk levels that banks take on in their eager hunt for profits. One unexpected and possibly unforeseen result of these regulations will be to undermine bullion bank trading in unallocated gold metal. Here’s where it gets really interesting.

Most bullion traded is not physical but a derivative, such as via an exchange traded fund (ETF) and settled on an unallocated account basis. Under this the customer does not own the gold but has only a general entitlement to an amount of metal. Not only does a customer with an unallocated account not own the gold; they are just a creditor of the bank. Legally, they are merely a depositor of gold. So, when, or if that bank collapses the person holding unallocated gold will have to stand in line with many other creditors all trying to get their money back. Bullion banks engage in what could be called ‘fractional precious metals trading’; they trade far more gold than they hold in their vaults. All unallocated gold obligations appear on the bank’s balance sheet.

Gold fans have already started salivating at the possibility of much higher gold prices as a consequence of the introduction of Basel 3; they see a decline in the trading of unallocated gold and a higher gold price. But for now, the link between any potential decline in the trading of unallocated gold and a higher price is purely hypothetical.

Source: Bullion Star

Paper promises

There are about 35 bullion banks active in the global gold market. The London Bullion Market Association (LBMA) says it has 76 full members around the world – refiners, dealers, traders, banks and others. This includes 12 market makers, who are obliged to provide buy and sell quotes. Market members pay the LBMA £26,500 a year for their membership.

In London, all bullion trade is done by a group of bullion banks through a private company called the London Precious Metals Clearing Limited (LPMCL). The majority of gold held by the LPMCL clearing banks is unallocated; this gold can be lent and is held on the bank’s balance sheet. In March alone this year more than 600 tonnes of gold, valued at more than $34 billion (about £24 billion) was bought or sold – ‘cleared’ through the LPMCL. Global mine production in 2019 was 3,300 tonnes of gold. Over the course of a year much more gold is traded than the annual supply. How is that possible?

The answer is that most of this gold is traded via the derivatives market, or contracts that derive their value from an underlying entity. Paper, in other words.

Metal shortage ahead?

Allocated gold is never recorded on a bank’s balance sheets, simply because the bank doesn’t own it; Basel 3 is all about trying to minimise systemic risk in banking, so balance sheets are what count. Bullion banks’ unallocated gold however is recorded on their balance sheets. Basel 3’s NSFR (Net Stable Funding Ratio), would require the banks to hold 85% of the value of this gold. So, to comply with the NSFR banks would either have to create a huge increase in their shareholders’ equity to provide the required reserves, or their dealing in unallocated precious metals will become very much more expensive and also difficult to fulfil. They are unlikely to take custody of many times the quantity of physical precious metals that they now hold – there just isn’t enough physical metal available. Nor do they have the storage capacity to hold enough physical gold.

The bottom-line implication of Basel 3 is that, according to some, trade in unallocated metal in London and New York would be “wiped out”.

All this debate is entangled in conspiracy-minded allegations about how central bank gold lending, with commercial bullion banks willing participants, is done to artificially repress the gold price.

Will Basel 3 become implemented in full or diluted? Some powerful lobbying against Basel 3 has already been started by two of the most powerful forces in the gold world – the London Bullion Market Association (LBMA) and the World Gold Council (WGC). They have sent a joint protest letter to the Prudential Regulation Authority, the UK’s banking regulator, saying “the effects [of Basel 3] would not just be limited to the London OTC (over-the-counter) market but would be felt globally across the entire gold value chain”. So, it may be that Basel 3 gets watered down. It’s too early to tell.

Basel 2 failed, according to one academic, because of ‘regulatory capture’ – “large international banks were able to systematically manipulate outcomes in Basel II’s regulatory process to their advantage, at the expense of their smaller and emerging market competitors and, above all, systemic financial stability”. The fate of Basel 3 – the future price direction of gold – may hinge on the power of “large international banks” which can dictate “the regulatory agenda”. Or on the degree to which the Basel regulators might resist being taken hostage.

I have no opinion on the allegations about the suppression of the gold price. But I do have an opinion on how you should hold your gold – in an account that specifically allocates the gold to you. Glint is not a bank, it is not a member of the LBMA and gold is not regulated by the Financial Conduct Authority. If you hold gold through Glint, no-one can lend, borrow, or otherwise mess with it. Meanwhile, we need to keep an eye on Basel 3.

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